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Chapter 11
Insurance
Contracts
Legal Framework of Insurance
• Requirements of a valid contract
• Characteristics of contracts
• Legal principles underlying insurance
contracts
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-2
Requirements of a Valid
Insurance Contract
• Offer and acceptance
• Consideration
–
In most states contracts can be oral or written
• Capacity
• Legal Purpose
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11-3
Valid Insurance Contract - Offer
and Acceptance
• A meeting of the minds between the
parties of the contract. Does this really
exist in insurance?
• Who makes the offer?
–
Applicant always makes the offer
• Property insurance:
–
–
Agent solicits offer, applicant offers, agent
accepts (binds)
If the company does not want the contract, it
may cancel the contract according to the
contract’s cancellation clause
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-4
Valid Insurance Contract - Offer
and Acceptance
• Life insurance:
–
–
–
–
Agent solicits offer
Applicant offers
Insurance company accepts, rejects, or
counter offers
Counter offer may be accepted or rejected
by the applicant
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-5
Valid Insurance Contract Consideration
• Property: monetary payment and an
agreement to abide by conditions and
stipulations in the contract
• Life: monetary payment and making
truthful statements in the application
–
Checks must be honored by bank before that
part of the “consideration” is fulfilled
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-6
Valid Insurance Contract Capacity
• The legal ability to enter into a contract
• Capacity is assumed except:
–
–
–
–
Minors
Insane
Intoxicated
Corporation acting outside the scope of its
charter
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-7
Valid Insurance Contract – Legal
Purpose
• From society’s standpoint “insurance”
needs to be for a legal purpose
– It shares and redistributes the cost of losses
– It must not encourage or protect illegal
activities
• From an individual contract’s point of
view
– Individual insurance contracts cannot pay for
certain losses. (e.g. individual buys a life
insurance contract with the intent to murder)
In this case the contract is perfectly legal but
the use and intent is malicious so the contract
cannot be enforced.
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-8
Insurance by Type of Contract
• Aleatory - dollar outcome is assumed unequal
• Conditional - performance is conditional upon
the occurrence of an uncertain event
• Adhesion - ambiguities are construed against
the writer of the contract
• Personal - requires privity of contract –
cannot freely exchange parties to the contract
• Unilateral - only one party has to perform the insurer
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-9
Legal Principles
• Principle
• Principle
• Principle
• Principle
of
of
of
of
Indemnity
Insurable Interest
Subrogation
Utmost Good Faith
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11-10
Legal Principles - Principle of
Indemnity
• Principle of insurable interest determines
if a loss is suffered; the principle of
indemnity places a limit on the amount of
the loss.
• A person may not collect more than the
actual loss sustained - cannot make a
profit
• The best that one can hope for is to be
placed in the same financial position after
the loss compared to before
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11-11
Legal Principles - Principle of
Insurable Interest
• Must demonstrate a “loss” to collect
–
Would be gambling or intentional loss if
an insured could collect with no
personal loss
• Insurance is a “personal” contract
–
Follows the person - not the property
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-12
Legal Principles - Principle of
Insurable Interest
• What constitutes insurable
interest?
–
–
–
–
–
–
Ownership
Leases (in some cases)
Secured creditors (not general creditors)
Legal liability
Care, custody, and control
Life insurance - exists for person voluntarily
insuring ones own life - others must have
insurable interest
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11-13
Legal Principles - Principle of
Insurable Interest
• When must the insurable interest exist?
–
–
Property insurance - must exist at the time of
the loss
Life insurance - must exist at the inception of
the policy; continuing insurable interest is not
necessary
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-14
Principle of Indemnity
Actual Cash Value
Actual Cash Value = Replacement Cost Less
Depreciation
ACV
loss
= [RC
loss
– DEP
loss]
RC = the cost to repair or replace with like kind and
quality of material
loss = calculation is performed only on the part that
was damaged
DEP = A measure of “betterment”
Not an accounting concept
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-15
Principle of Indemnity
Exceptions
•
•
•
•
Valued policies
Valued policy laws
Replacement cost coverage
Life insurance - not an indemnity
contract
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11-16
Legal Principles
Principle of Subrogation
If insurance did not exist
injury
Injured
suit
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Negligent
party
11-17
Legal Principles - Principle of
Subrogation
One who indemnifies another’s loss is
entitled to recovery from any liable third
parties
Negligent
party causes
injury
Injured
insured
Insurer
pays
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
Insurer subrogates
against negligent
party
11-18
Principle of Subrogation
• Reinforces the principle of indemnity can only collect once
• Holds rates below what they would
otherwise be - salvage
• Places burden of the loss on those
responsible (i.e. negligence)
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11-19
Principle of Subrogation
• Subrogation does not exist where the
principle of indemnity does not apply - life
insurance
• Subrogation is ALWAYS waived for AN
INSURED
• If an insured violates or destroys insurer’s
subrogation rights, insured may forfeit
collection rights under the contract
• The insurer is entitled to subrogation dollars
only after insured has collected fully for the
loss
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-20
Principle of Subrogation
Example
Insured has
$10,000 loss and
recovers $7,000
from insurer
Insurer pays
$8,000 less $1,000
Deductible
injury
Negligent Party
pays $5,000
subrogates
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$3,000 to insured
$2,000 to insurer
11-21
Principle of Utmost Good Faith
• Higher standard of honesty is imposed
on insurance contracts as compared to
other contracts
• Categories of abuse:
–
–
–
–
Material misrepresentation
Material Concealment
Breach of a warranty
Breach of utmost good faith
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11-22
Principle of Utmost Good Faith
Representations
• Statements made before a contract
starts to induce a party to enter the
contract
• Oral or written statements
• Contract can be avoided if the
representation is false and material
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11-23
Material Misrepresentations
• Material Misrepresentation Tests
–
–
False - not true at the time of the statement
Material - would the insurer have declined
the contract, changed the wording, or
priced it differently if the truth were known
• Statement of opinions are not sufficient
to avoid the contract
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11-24
Principle of Utmost Good Faith
Concealments
• Silence when there is an obligation to
speak
• Utmost good faith imposes a duty to
voluntarily divulge material
information
• When a material fact is concealed the
insurer can avoid the contract
• Generally involves an element of
deception
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11-25
Tests for Concealment
• Did the insured know of a certain fact?
• Was the fact material?
• Was the insurer ignorant of the fact?
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11-26
Principle of Utmost Good Faith
Warranties
• A warranty creates a condition in a
contract
• Any breach of warranty, even if not
material, will allow the insurer to avoid
the contract (strict interpretation)
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-27
Types of Warranties
• Express - written
• Implied - not written, understood by all
• Promissory - condition to continue
throughout contract period
• Affirmative - exists at contract’s
inception; promises nothing about the
future
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11-28
Warranties - Examples
•
•
•
•
Implied affirmative
Implied promissory
Express affirmative
Express promissory
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11-29
Principle of Utmost Good Faith Breach of Utmost Good Faith
• Commonly referred to as a “bad faith
claim”
• Used when the insured feels the insurer is
not acting in “good faith”
• Used to force insurance companies to
perform according to the contract
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-30
Basic Parts of an Insurance
Policy
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31
11-31
Standardized Insurance Policies
- Why?
• More economical to print and maintain
• Eases the development of rates - given a
standard coverage set
• Loss and claim data of different companies
can be combined to provide more credible
data
• Meaning of standardized policies becomes
known to attorneys, courts, insurer’s
employees, and consumers
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-32
Standardization of Contracts
• Not all US policies are “standard”
–
–
Personal and Commercial policies are generally
standardized – variations are found
The larger commercial policies can be
“manuscript” but based on standard clauses
• Many international policies are
standardized too
–
–
Several Spanish-language (South American)
policies are translations of US policies
Austrians use standardized HO and Auto policies
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11-33
A NON-Exhaustive List of
Questions to Ask
•
•
•
•
•
Is the property / event / liability covered?
Is the person sustaining the loss covered?
Is the loss caused by a covered peril?
Do any exclusions apply?
Are there any special / sufficient limits or
penalties?
• Do any deductibles apply?
• Are there any territorial restrictions?
• Did the loss occur during the policy period?
© 2013 Pearson Education, Inc., publishing as Prentice Hall. All rights reserved.
11-34
Basic Parts of an Insurance
Contract - Declarations
• Personalizes the insurance contract to the insured
– What makes this contract different than others issued?
• Usually first page of an insurance contract
contains such things as:
–
–
–
–
–
–
–
Identifies the insurance company
Identifies the named insured
Policy period
Policy limits
Deductibles
Premium
Identifies forms and / or endorsements
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11-35
Basic Parts of an Insurance
Contract - Insuring Agreements
• Broadly describes what is covered and the
insurer’s and the insured’s rights,
obligations, and duties
• Examples from:
– Homeowners (HO)
– Auto (PAP)
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11-36
Basic Parts of an Insurance
Contract - Deductibles
• Straight deductible - amount paid by insured
before the insurer pays any money
– Example: from the loss v. from the claim
•
•
•
•
$25,000 loss
$20,000 coverage
$ 1,000 deductible
Deductible from the loss
– $25,000 - $1,000 = $24,000; $20,000 paid because
hit policy limit
•
Deductible from claim
– $20,000 - $1,000 = $19,000; deductible taken from
claim
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11-37
Basic Parts of an Insurance
Contract - Deductibles
• Reasons for deductibles
–
–
–
Reduces moral and morale hazard since insured
pays a small portion of each loss
Eliminates the expenses involved in small,
frequent claims and most losses are small
As a result premiums are lower
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11-38
Basic Parts of an Insurance
Contract - Definitions
• Clarify meaning of words and terms in
contract - [remember the doctrine of
adhesion]
• Found in definitions page, glossary, or
throughout the contract
• Reduces the word count in insurance
policies
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11-39
Basic Parts of an Insurance
Contract - Exclusions
• Identify losses that are not covered
• Designed to:
–
–
–
–
–
Eliminate catastrophic events - flood, war
Eliminate moral or morale hazards - intentional
loss, failure to protect property
Require extra charge - unfair to charge all
insureds for covering $100,000 gun collections
Eliminate coverage where another policy is
specifically designed for the coverage
To truncate the doctrine of proximate cause
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11-40
Basic Parts of an Insurance
Contract - Conditions
• If you want the claim paid, you must meet the
conditions stated in the contract. These
include:
–
–
–
–
–
–
–
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No Concealment or Fraud
No Suspension of coverage
Cancellation – policy must be in force
Other insurance does not apply or loss is shared
Meet your duties after a loss
Abide by the appraisal procedure
Agree to salvage
Agree to claims payment - time limits
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11-41
Basic Parts of an Insurance
Contract - Endorsements
• Modify standard insurance contracts in
predetermined ways - examples
–
–
–
Expand coverage
Delete exclusions in contract
Change definitions
•
–
–
e.g.: “ sporadic baby-sitting is not a “business”
Add locations / insureds / perils
Add additional insureds
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11-42
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11-43